4/15/2009 @ 12:01AM

A Captive FDIC

The most successful policy response to the banking crisis of the 1930s was the creation of the Federal Deposit Insurance Corp., which resulted from an amendment to the Glass-Steagall Banking Act of 1933. President Franklin D. Roosevelt opposed the creation of the FDIC, as did many leading bankers in the big money centers.

Nevertheless, this one institution was responsible for calming the fears of depositors and ending bank runs. Its creation was followed by many decades of relative stability in the financial system. Now, the integrity of the FDIC is threatened by pressure from those it is meant to regulate.

The Banking Act required that all banks that were members of the Federal Reserve System have their deposits insured, up to a limit, by the FDIC. Other banks could also be covered, subject to approval by the insurer. Insured banks were required to pay premiums for their insurance based on their deposits. Within six months of the creation of the FDIC, 97% of all commercial bank deposits were covered by insurance.

The FDIC has been a successful institution because it solved a well-defined problem–uncertainty about the solvency of the banks. More importantly, it did so in a way that acknowledged the contradictions and risks inherent in fractional reserve banking by making those responsible for the risks pay for insuring against them.

As is always the case with regulation, the institutions regulated by the FDIC have sought over the years to minimize the cost of FDIC insurance. One example of this occurred in the aftermath of the Savings and Loan Crisis of the 1980s, when the Savings Association Insurance Fund (SAIF) was taken under the umbrella of the FDIC.

Insurance Rates for SAIF were much higher than those for commercial banks under the Bank Insurance Fund as a result of their recent history of failures. The result was that banks worked hard to qualify as eligible for the lower-premium BIF.

Banks also lobbied Congress hard to limit the size of the insurance fund. These were set at 1.25% of insured deposits. It wasn’t until passage of the Federal Deposit Insurance Reform Act in 2005, when some flexibility was introduced into the formula, that insurance rates could be tied to risk assessments of the institutions. Following those reforms, the requirement was that the insurance fund stay between 1.15 % and 1.5 % of all insured deposits.

For many years, including the recent boom years of ever-increasing profits and risks, the banks paid nothing into the insurance fund. And then came the crisis.

Twenty-five banks failed last year, and 23 have failed so far in 2009. Some of the failed institutions–IndyMac, for example–were very large. The reserve ratio as of Dec. 31, 2008, was 0.4%, down from 1.22 % at the end of 2007. It has fallen further since. FDIC Chair Sheila Bair has warned that the fund could quickly be wiped out if more fees are not assessed on the banks.

The FDIC has proposed significant new premiums as well as an emergency assessment that could collect up to $27 billion. And how have the banks responded? With howls of anguish and increased lobbying efforts to get the FDIC to back off. The banks’ claim is that we cannot expect them to pony up more when they are weak, and would will be forced to raise fees and curtail lending.

Sadly, the FDIC has caved, asking Congress for the authority to borrow $500 billion from the Treasury (read: from taxpayers) in case they need it. This is a dramatic increase over their current statutory limit of $30 billion. If they get the line of credit, they will cut back the fee increases. Unfortunately, this changes the game, once again shifting risk to taxpayers rather than the creators of the risk.

The FDIC has also been expanding its mission throughout the crisis. In October, it introduced the Temporary Liquidity Guarantee Program to guarantee newly issued senior unsecured debt of banks, thrifts. For a fee of 75 basis points, the same for all regardless of their risk profiles, banks can issue unsecured debt guaranteed by the full faith and credit of the U.S. government.

This remarkable intervention was justified by invoking the FDIC’s statutory authority to prevent systemic risk. What is slightly odd here is that by providing essentially free insurance to these institutions, the FDIC could be substantially increasing systemic risk and the risk to taxpayers.

The FDIC is also part of the plan to insure losses on the Public Private Investment Partnership proposed to help rid banks of their “legacy” assets. Who will pay the premiums for this insurance? Apparently not the investors, and that means the risks will again be shifted to taxpayers.

Successful, well-designed regulatory institutions are a rare thing. The FDIC is a good example of an institution that, for the most part, solved the right problem at the right time in the right way. What a shame if it gets captured by the politicians and the banks.

Thomas F. Cooley, the Paganelli-Bull professor of economics and Richard R. West dean of the NYU Stern School of Business, writes a weekly column for Forbes.